Is Pay Too High and are Incentives Too Low? A Wealth-Based Contracting Framework

Abstract

In the wake of the recent financial crisis, US executive compensation has, once again, come under fire from regulators, politicians, the financial press, the general public, and some academics. Although the critiques are varied, many identify the level of pay and performance-based incentives as two key areas of concern. And, as is often the case in the wake of a crisis, proposals have been put forward to resolve the “problems” with executive pay and incentives. A deficiency with all of these proposals, however, is the failure to articulate a framework for determining the appropriate level of executive incentives. Rather, the proposals simply discuss ways firms or regulators might get executives to hold greater incentives without identifying how one should determine whether or when an executive has enough (or too much) incentives. In this paper, we lay out an economic framework for thinking about how much performance-based incentives an executive should have. In doing this, we emphasize how performance-based incentives are linked to executive pay levels, as well as to the level of executives’ wealth. We also make clear both the benefits and costs of performance-based incentives.